Financing for Small Businesses: Where and How to Find It
One of the biggest hurdles to jump when opening your own small business is getting financing. Just the idea of spending your nest egg can seem daunting. But there are other ways to finance your business—mainly borrowing money, finding inventors, and getting grants. In this guide we’ll take you through all of your options for financing your new venture.
The ABCs of Loans
When your business borrows money that has to be paid back along with interest, this is called a loan. If you borrow from a financial institution, you’re dealing with a commercial loan. If you borrow from your mother-in-law or best friend, you have a private loan.
Loans have a language of their own. You (or the business) are the borrower, or debtor. The bank or other lending source is the lender, or creditor. The time during which you have the use of the money you borrow is called the term or period of the loan. This is also called the loan’s maturity. The amount you borrow from the lender is called principal.
There are two main types of borrowing: a lump-sum loan, where you receive all the money at once and then repay it; or a line of credit, where you are authorized to use funds up to a set limit when and to the extent you need to. Say you receive a $5,000 line of credit. You can take the money all at once or use $1,000 now and reserve the rest for another time.
As fascinating as your business is, the lender is not really interested in the intricacies of the product you sell or the service you provide. The main thing a lender wants to know is whether he will get his money back. The lender doesn’t benefit from your profits (beyond money used to pay back the loan). The lender doesn’t own any part of your business. (Of course if you fail to repay the loan, the lender may be able to take your house or car, but let’s not even go there.)
When you’re looking for a loan for your business, the lender is looking closely at you as much as he is at the business. The reason? As the owner of a small business you’ll be asked to co-sign or guarantee the loan. In other words, the cash will go to the business, but if the business goes under, your friendly bank manager will come knocking on your front door for repayment. Therefore, your personal credit history will affect whether you can get a business loan.
Obviously, your first line of defense in finding a loan is going to people you know, including a wealthy cousin, a best friend, or a well-heeled neighbor. Also look for banks already proven to be small-business friendly and willing to loan money. These banks are in the Small Business Administration’s Directory of Small Business Lending at www.sba.gov/ADVO/stats. The Small Business Administration (SBA) itself does not make loans; it simply guarantees a percentage of the loan amounts for banks as a way of encouraging them to lend to small businesses. To view the different SBA loan programs, go to www.sba.gov/financing/index.html.
Bringing In Investors and Equity Partners
If you don’t want to borrow or can’t qualify for a loan because of bad personal credit, your only choice may be to share your business with one or more people. When you do this, your investors become your equity partners—they share in the success of your business.
The most obvious way to get an investor is to find someone who will work alongside you as a co-owner. After years of talking over the back fence with your neighbor about going into business together, now is the time to pool not only your talents but also your financial resources to get started.
Unfortunately, you may not be able to find someone to work with you as a full-fledged co-owner. Still, if you need the outside financing, you must look for a “silent partner” or two to put in money but leave the running of the business up to you. Obviously, family and friends are an easy target for assistance.
As a rule of thumb, a private investor, sometimes called an angel (other than perhaps a relative or a friend), is looking for a high return on investment (as much as 25 percent or more) in a relatively short time (usually less than five years). When Aunt Lottie invests in your company, her expectations might be quite different. She might not be looking for quick profit as much as she’s looking to help you out. (Of course, she doesn’t want to lose her shirt, either.)
Since you don’t have to pay anything back, the investor is less interested in your credit history (although they will definitely run a credit check on you) and more in the business itself. Is this the best idea since sliced bread? Is it practical? And, most important, will it make money so they’re not flushing their investment away? The answer to this last question, which the investor must answer for herself, is often the reason they decide to ante up.
When you look for investors, there’s no formal or established process like filling out a loan application. If you are looking for substantial capital, most prospective investors (outside of your family) will insist on seeing your business plan. If that sparks any interest, then the investor will meet with you before deciding to go any further.
Getting investors interested in your business to the point where they’re willing to put up cash may take weeks or even months. Then you generally involve attorneys in the process to formalize your arrangements. This, again, will take time.
Financing the Business on Your Own
Just because you don’t have a fat bank account doesn’t mean you don’t have resources available for your business. Here are some key places to look for money first, before you go anywhere else:
- Home equity. Usually, you can borrow up to 75 percent or 80 percent of the equity of your home through a second mortgage or a home equity line of credit (HELOC). Typically, the interest rate varies, so this borrowing can become expensive when interest rates rise.
- Life insurance. If you have a permanent life insurance policy, such as a whole life or universal life policy, you can borrow against the policy’s cash surrender value. The repayment is totally within your discretion—you can pay it back plus interest when and to the extent you want. Of course, should you die before repaying the loan, your beneficiary would receive less than you had anticipated; the outstanding loan is subtracted from the proceeds paid to the beneficiary.
- Retirement plan. If you have money stashed away in a 401(k) plan at work, or with an employer from a prior job, you usually can easily borrow from the plan. The law sets the limits on how much you can borrow: 50 percent of your vested benefits or $50,000, whichever is less. You must repay the loan in level amounts over a term of no more than five years. The interest rate charged on this type of borrowing usually is much lower than on a bank loan.
- Brokerage account. If you have stocks, bonds, and mutual funds sitting in a brokerage account that represent your savings for retirement, education, or some other purpose, you can easily arrange to borrow against your holdings for your business. This is called a margin loan. Again, the law limits how much you can borrow on margin, depending upon what’s in your account: usually up to 50 percent of the value of the securities in the account (90 percent if assets are Treasury securities). The interest rate adjusts regularly, but usually it is lower than the rate charged on a bank loan.
- Credit cards. About half of all small businesses use credit card borrowing to some degree. Just remember interest on a credit card can run 18 percent or more a year. Also keep in mind that the interest on purchases (supplies, trips, etc.) start at the end of the billing cycle, but pulling out cash starts the interest clock running the second you touch the greenbacks. If you must use a credit card to start your business, try to use only one for business expenses exclusively. This will help you when you’re doing your taxes later on.
Free Money: Grants
If you’re lucky enough to get a grant, you’ll have a continuing relationship with the grant maker for the term of the grant. You’ll generally have to do a certain amount of paperwork, sending in interim reports telling the grant maker how things are going and that you’re using the money the way you said you would. At the end of the grant term you also have to write a final report. The grant maker will also audit your books to make sure you haven’t spent the money on a vacation home in the Bahamas.
Grants usually come from two prime sources:
- The Government. There are grants designed for small businesses, but typically they’re not suitable for start-ups. There are, however, exceptions for special businesses. For example, Ramona, a retired teacher, applied for and received a government grant to provide tutoring services to inner-city children. Since the government often supports economic development for depressed areas, this was a great match.
- Private Coundations. Foundations are basically charitable organizations set up to fund projects they’re interested in. Some foundations give out seed money, which can be used to start up a business. Generally, however, like government grants, foundation money is designed to go to businesses that already have a track record.
Start by sending the government agency or foundation making the grant a letter of intent. This letter informs the grant maker that you want to submit a formal proposal, which is just another word for an application. The letter should contain a brief outline of your project—which may be simply to start up a business. Describe your business, your background, and any other key people you work with. Specify how much grant money you’re looking for and how the money will be used.
Remember, the government agency or foundation making the grant doesn’t know you exist. Your job is to make yourself sound fascinating and convince them that the grant should be given to you over thousands of other applicants.
From The Complete Idiot’s Guide to Starting a Home-Based Business, Third Edition by Barbara Weltman
